Investment Philosophy Matters When Generating Ideas
Dan Pickett
/ Categories: Company Analysis

Investment Philosophy Matters When Generating Ideas

Growth versus Value

Idea generation is about reducing a large universe of potential investments to the specific stocks you think might outperform the market and will research. A professional investor's investment philosophy plays a major role in narrowing the universe they consider; the philosophy reflects how they believe prices are set in the market, how opportunities develop, and how they can exploit those opportunities. Broadly speaking, investment philosophies fall along a spectrum with growth/momentum ideas at one end and value ideas at the other.

Growth investors seek stocks where the revenues, cash flow, and earnings are growing at an above average rate. For ideas they ultimately buy, growth investors are in effect saying the market may recognize the strong historical growth (i.e. the valuation is high) but doesn’t appreciate how fast future growth will be or how long the growth will persist. To put a behavioral spin on it, growth investors believe investors sometimes underreact to positive news like earnings surprises because a bias to anchor on their original forecast causes them to adjust their expectations too slowly. Growth investors believe in buying what is working and they expect will continue to work (trends will persist) – and believe their competitive advantage lies in estimating the value of growth assets. Ideas could come from positive earnings reports or interesting new product announcements.

Value investors seek stocks where the price is significantly lower than their estimate of the “intrinsic value” of the business. Usually that means the businesses have performed poorly and are out-of-favor or there is complexity to the business that makes it more difficult to appreciate the opportunity. For ideas they ultimately buy, value investors are in effect saying the market is penalizing the stock for a short-term problem, but that problem is only temporary and as the company recovers, the stock price will increase towards a value more consistent with the long-run potential of the business. From a behavioral standpoint, value investors believe investors sometimes over-react to negative news and that there is a bias to overweight recent events. Value investors believe in buying what is out-of-favor, but where they expect to see improvement toward some measure of historical performance (regression to the mean) – and believe their competitive advantage is in estimating the value of existing assets. Ideas could come from reading about a company’s problems in the Wall Street Journal and noticing its stock is at a 52-week low or recognizing the stock’s valuation has declined significantly.

There are many techniques for identifying stock ideas and starting with an underlying philosophy can help narrow the universe. Obviously just finding a company with new products or selling at a low valuation won’t guarantee subsequent strong stock price performance, but it can help you focus the research you need to do in order to make your own judgement. In subsequent posts we’ll describe some Factset screens you can use to find potential growth and value ideas. If you want to get a head start, take a look at the Factset references in the attached Identifying ideas presentation. The listed screens are saved in the CMC folder on Factset for your use.

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